Not long ago I saw the film The Big Short, which tells the story of some of the people behind the infamous housing-market crash of 2008. The film manages to be educational while maintaining an entertaining aspect, and also contains many abstract and potentially difficult financial concepts. I have also been reading The Intelligent Investor by Benjamin Graham, who was a teacher and mentor to Warren Buffett—one of the richest people in the world and a role model for many modern investors.
Investing is a highly complex field with a unique vocabulary of its own. Trying to get a better understanding of investing lingo, I recently spoke to an investment advisor who works in Ithaca. The advisor agreed to sit down and talk with me in Buffalo Books on January 12 to explain some key concepts in the business of investing. He was generous with his time and happy to explain the key terms of investing to me, though he said that he would prefer for me not to mention his name or firm; he is, however, a graduate of IHS, where he said his favorite subject was social studies. Not surprisingly, he told me he has great respect for Warren Buffett, declaring the wealthy but humble founder of conglomerate corporation Berkshire Hathaway one of the smartest investors ever.
I asked him about his job as an investment advisor. He said that he works
with people on their private investments and retirement accounts and helps people manage money in a way that lets them grow and/or maintain their current level of money. As part of his job, he advises individuals on retirement savings, and on how to pay off debts. An investment advisor can be very helpful for people who are struggling with their own finances, or just those looking to properly manage their investments, and can give them a sense of direction.
Next, he explained the difference between investors, traders, and brokers. Those interested in becoming investors are usually advised to take a long-term approach. That means putting money in things that may not result in immediate payoff, but will hopefully appreciate and provide a return in the long run. Traders, on the other hand, usually take a more short-term stake in their investments than an investor would, actively buying and selling securities. A broker is someone who buys and sells stocks, bonds, and mutual funds on behalf of someone else as a middleman.
I asked him about hedge funds, currently a topic of large debate that we hear about rather frequently in the news and movies such as The Big Short. Hedge funds, he said, are private funds with stocks and bonds or real estate or mutual funds that attempt to beat the market return-wise, typically by employing aggressive tactics. As hedge funds are highly complex financial institutions, it’s necessary to consistently generate over $200,000 a year or have a net worth of $1 million or more to qualify to invest in a fund.
Following this, he went over what an acquisition is. An event relatively common in the financial sector, an acquisition is when one company purchases another company’s corporate assets and liabilities, keeping it otherwise intact unless they wish to initiate reform of some kind. However, an acquisition is not necessarily a mutual agreement between two companies, as hostile takeovers can occur when one company forcefully buys out another company.
The term “option” is used fairly frequently, especially by traders. Options are financial instruments used to extend profits but can be risky and very confusing, even for professionals. Essentially, by purchasing an option, you are buying a position in the market where you are either betting on the underlying stock to either go up or go down (call and put, respectively). When you acquire an option, you obtain the right, but not the obligation, to actually utilize it. As an example, let’s say the value of a market index (a term explained below) is 100. You can buy call at 105, and by purchasing it, you bet that it will go up to 105; if it goes up above 105, you will make a whole bunch of money. The price that you get an option at is the price at which it has to be bought or sold on that day. The difference between that price and the closing price you get to keep. To profit, it’s necessary to either sell at a steep discount or buy on a big discount. Note that options have expiration dates after which they become unusable.
The financial instrument called a bond is of importance to The Big Short. A bond, the advisor explained, is a form of debt that has been issued by a company or government that can be bought or sold just like stocks. A bondholder can collect income from the bond as the bondholder pays off the bond. Bonds are also different from stocks in that they are considered relatively safe investments because there is less fluctuation.
The 2008 crash was central to the storyline of The Big Short, but what caused it? Although there were quite a number of reasons for this devastating event, major causes blamed for the crash include artificially inflated home real-estate prices and the proliferation of subprime mortgages. This led to a domino effect that brought banks to a crisis point, which required government intervention—in the form of taxpayer money—to prevent massive losses and the complete collapse of the financial system.
Next, the advisor explained the meaning of various acronyms:
S&P: Standard and Poors, a rating agency for bonds. S&P assigns credit ratings for bonds based on their likelihood of issue defaulting (when the bond issuer can’t afford to pay back its bondholders). They also maintain and create market indexes such as S&P 500. They generally focus
NASDAQ: A stock index like the S&P 500, and also a stock exchange on its own. It is comprised of mainly technology-industry stocks.
SEC: Securities and Exchange Commission, a branch of government that is responsible for regulating people who work in the financial services industry and the stock market. They try to enforce laws and make sure that nobody cheats the system or clients.
IPO: Initial Public Offering, when a company makes their stock available to be bought by the public for the first time. Usually “underwritten” by a middleman investment bank that assists the company in issuing its first shares to the public.
P/E ratio: Price to Earnings, also expressed as stock price divided by the earnings per share of the underlying company’s stock. The P/E can be used to gauge how undervalued or overvalued a specific stock is, both by the company and the investor. A high P/E ratio may signal that the stock’s price is too high in relation to its earnings or that people are interested in the stock for reasons other than earnings. The P/E ratio is one of the most common ratios in investing.
HFT: High-frequency trading, the act of buying and selling stocks at very high rates. A high-frequency trader capitalizes on micro-fluctuations in the stock market by selling when the price of the stock appreciates slightly and buying when it decreases slightly. These tasks are most typically automated through the usage of computers that utilize mathematical techniques and algorithms to attempt to figure out which stocks to purchase or sell. There are numerous firms that specialize in high-frequency trading and the technology behind it.
Finally, he went over some key terms every investor should know:
Dividend: A payment that some stocks (and bonds) will deliver to their shareholders from time to time. If you own a stock, you can be paid a dividend if the company has a dividend policy. The typical dividend pattern is to pay out every quarter, although there are variations on this scheme.
Stock Split: A company may perform a split to keep stock prices low and hopefully sell more shares of their stock. Say somebody has stock in Apple around 115. If a 2:1 split happens then the owners of the stock prior to the split would have two shares at 57.5 each. Newly issued shares would be sold at that lower price.
Blue Chip Stock: Financial speak for a company with a solid reputation that will likely continue to display good results at that time. “Blue Chip” means that the stock is recommended and the general public is confident that it will do well due to it it having a proven history and record.
Junk Bond: A bond issue that has a high rate of defaulting. However, they tend to pay out higher yields. Becoming notorious during the 80’s, junk bonds are considered such if they have a rating of “BB” or lower on the typical bond-rating scale.
Penny Stock: Essentially the stock equivalent of a junk bond. They typically take the place of small companies that aren’t worth very much. Penny stocks tend to be very volatile to buy and sell with large price fluctuations and bankruptcy not being a rare sight. However, they have the potential to earn lots of money if they do turn out to be huge successes due to the fact that they can be purchased at such a low price.
Beta: A way to measure volatility of individual stocks in comparison to the market as a whole. The market has a beta of 1. Most stocks have a beta either higher or lower than this, with a high beta showing that it is (in theory) more volatile than the general market. Beta is used to measure history and anticipate future risk.
Mutual fund: A group of stocks and bonds that will be selected and dealt with by a fund
manager or a team of multiple managers, as is the case with larger funds. There are a large variety of mutual funds focused on specific sectors of the market or made to fit the different needs of people and meet their goals. They tend to be much more available to the public than hedge funds.